January sales and Bozo’s circus

It has been brought to the attention of The Escape Artist that during the first part of January there were some sales going on 1) in the shops and 2) in the stock market.

For reasons that are not entirely clear, we are invited by the media to celebrate the former and panic about the latter.

But if it’s a good thing when shoes and kitchen appliances fall in price, why isn’t it also a good thing for savers when shares fall in price?

Let’s start with some perspective on what happened during 2015. During 2015 my portfolio of directly held shares delivered a 12.2% total return (dividends plus increase in capital value). In comparison, the FTSE All Share index delivered a total return of 1% in 2015. So my directly held shares outperformed it by 11 percentage points.

I also hold low cost, index trackers to achieve broad international diversification and emerging market exposure. The performance of these over the year was nothing to shout about, with my mix of index tracking ETFs delivering a distinctly unexciting -1.5%.

I look at this as index trackers just doing what they are designed to do and faithfully tracking the underlying indexes at low cost. Because I hold these ETFs to provide diversification, I can’t be too surprised when they underperform in years when my share picks outperform.

Even in a year when my stock picks outperformed the indexes by a big margin, the process still felt uncomfortable at times. The overall portfolio performance was good but I still felt the pain of a couple of individual stocks underperforming. Losses on shares that we’ve picked ourselves somehow feel more personal than with index investing. This is one reason why most people are better off starting with index trackers.

Yes, index investing is incredibly simple. Its as easy to open an online broker account and buy an ETF as it is to open an online bank account. But the real reason I think low cost index investing is the best route for most people is that its easier not to take the volatility personally and feel regret, shame, fear or other unhelpful emotions.

I don’t regret the 1.5% “loss” from my ETFs as I know its just part of the normal process of investing and its nothing personal. In fact, I don’t even see it as a loss. I haven’t sold any units in my index tracking ETFs (in fact I added more) and my target holding period is forever.

As a comparison, think of the score 5 minutes into a 2 hour long basketball game: its of great interest to the fans and the players. But its usually not much more of a reliable predictor of the final result than a 50:50 coin toss.

A big difference between sport and investing is that in investing it can actually be an advantage to spend much of the game “behind”. Funds and shares are not like people in that they don’t get discouraged after they under-perform.

Lower prices mean better value and higher future expected returns for investors. So the longer that share prices are low during our period of net saving, the better for us…even though it doesn’t feel that way. So when investing, its best to be more aggressive and buy at times when share prices and valuations are lower…even though we may be feeling rattled by recent price falls.

Below is a table from the excellent book Elements of Investing showing how volatility helps someone working and saving for retirement:

This shows the benefits of £ / $ cost averaging through a period of a flat volatile market (that feels uncomfortable) compared to a smoothly rising market (that feels better).

The lower the index level at the time of investing, the more units each £ / $ buys and so the more shares in real businesses with real assets the investor ends up owning.

The investor’s portfolio ends up worth more in a flat, volatile market…even with a price level 28% lower at the end of year 5,. And the difference in the number of shares owned is striking. The investor in the flat, volatile market ends up with 42% more shares.

I know it doesn’t feel like it but lower share prices are good for everyone still in the wealth building phase i.e. pretty much anyone still working who has not yet reached financial independence.

It is not only working savers that benefit from lower share prices. Lower share prices are also good for people after financial independence who are still saving. Much to my own surprise, I’ve ended up in this position.

And yet, irrational though it may be, The Escape Artist must confess to feeling slightly queasy if I spend too much time looking at share prices and news during a period of falling prices. Even if my logical side knows that every fall means more value, more units and more dividends for my future purchases.

One technique that helped me internalise the benefits of lower share prices was to think about equities as if they were bonds where the future interest payments (aka dividends) have been fixed….its just that with shares we don’t know what those future dividends will be.

I promise you The Escape Artist is not making this shit up. If we assume that dividends are going to be what they are going to be, then we can mathematically prove that lower prices mean higher returns for us as investors.

The formula is simply: Re = ( div t+1 / P ) + g

Where:

Re= the investors return

div t+1 = the next annual dividend

g = annual rate of future dividend growth

P= the price level

Let’s put some numbers to that. If the FTSE 100 price level is 6,500 and the dividends are 286 and will grow at 3% per year, then the investors return will be 7.4% per year.

If the FTSE 100 then falls to 5,500 and the dividends are still 286 and will still grow at 3% per year, then the investors return will be 8.2% per year.

The problem with share price falls is that we often interpret them as signs that the underlying prospects of a company or market have got worse and that future dividends will be lower. That may sometimes be true at the level of individual companies, for example after a profit warning.

But its almost never true at the level of a broad index like the S&P 500 or FTSE 100. When the stock market falls, the companies in that index remain unchanged for the most part. They own the same assets as before and they will earn the same future profits and pay the same future dividends to us as investors. So if we are still saving, we should actually welcome lower prices.

Warren Buffett puts it this way:

If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.

But if you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the “hamburgers” they will soon be buying.

This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.

One of the greatest distractions from this fundamental truth of investing are the predictions of doom that are relayed by the financial media, usually after falls in the stock market. As an example, a reader recently sent me a link to a newspaper story titled:

Sell everything ahead of stock market crash, say RBS economists

This would have been more accurate had it been titled:

Sell everything and then buy it back, say brokers looking for commission

As Warren Buffet says: Never ask a barber whether you need a haircut. To which we might add: Never ask a broker whether you should be trading more. And: Never ask RBS how to avoid a financial crisis.

Economists at work

Is it just me or is anyone else amused to see The Guardian pimping out investment bank marketing materials in between its earnest articles about income inequality, bankers bonuses and chardonnay socialism?

Now I could get all worked up about this clown circus and the gushing geyser of guano used to fill up web space and media airtime, sell advertising and keep the viewers in a state of fear.

But instead The Escape Artist has, in a moment of Zen enlightenment, decided to accept that the clowns are gonna continue performing the circus whatever I say.

So I’m not going to get mad, I’m just going to keep the screen turned off and play the hand I’m dealt.

Focusing on what we can control means taking advantage of the opportunities presented by cheaper share prices. When investing, if you see people panic selling, the right thing to do is to get on the other side of that trade.

Passive investors trust that regular £ / $ cost averaging will get them most of these benefits. Active investors like The Escape Artist look for value opportunities trying to eke out a few extra points of performance buying at lower prices.

Either way, what we should be doing is find a way to not only to tolerate volatility but also to embrace and benefit from it.

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13 comments

If holding ETFs for diversification would it not be better to hold assets that provide diversification (Gov bonds)? Not exposure to cash flow negative junk you wouldn’t poke with a bargepole if you saw what goes into the sausage meat!

Nice post TEA. I just finished reading ‘Winning The Losers Game’ that’s on your recommended list of books (Xmas prezzie!) . When you read that, its difficult to believe that anything, other than an index tracker, is worth considering. Everything reverts to the mean of 9.7% yet there isn’t a single year when the index has actually produced 9.7%. Like you, I intend to hold onto my trackers for life so always make sure I have some cash to pick up cheaper shares.

Nice post and very timely given the current volatile start to the year, your spot on in saying its counter intuitive to see volatile markets as the regular investors friend, but the table proves otherwise. I enjoy following youre blog, it reinforces a lot of sound advice at just the right time.

Ok, if cheaper shares are good news for net savers (accumulators) then they are bad news for net spenders – ie people who are now living off their nest egg rather than creating it. Do you have any wise words for those in that position?

Great to see that example of the “flat” market. I’ll point people to this post next time I get any naysayers pontificating that no one will have made any money in the stock market in the last 10 years as it’s been flat.

The idea that the current state of the market is well-timed given my last great push of accumulation has been vaguely kicking about in the back of my mind. Thanks for solidifying the concept. I feel calmer.

Love it! Every time I see the market go down, I think “sale”. We can be opportunistic with everything we buy. We can dollar price average AND invest additional funds when there’s a FIRE sale…yes, pun intended😉.